IM| SciencesFinancial Management Should we build this plant? The Basics of Capital Budgeting:...
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Transcript of IM| SciencesFinancial Management Should we build this plant? The Basics of Capital Budgeting:...
IM| Sciences Financial Management
Should we build thisplant?
The Basics of Capital Budgeting: Investment Criteria and Evaluating Cash Flows
IM| Sciences Financial Management
What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
IM| Sciences Financial Management
Steps
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine r = WACC for project.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
IM| Sciences Financial Management
Incremental Cash Flows
Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter. (with or without the project)
Opportunity costs matter.
Be cautious about Fixed OH allocation
Side effects like erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.
IM| Sciences Financial Management
Cash Flows—Not Accounting Earnings
Consider depreciation expense.
You never write a cheque made out to “depreciation”.
Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.
IM| Sciences Financial Management
Incremental Cash Flows
Sunk costs are not relevant
Just because “we have come this far” does not mean that we should continue to throw good money after old.
Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.
IM| Sciences Financial Management
Incremental Cash Flows
Side effects matter.
Erosion; If our new product causes existing customers to demand less of current products, we need to recognize that.
IM| Sciences Financial Management
Estimating Cash Flows
Cash Flows from Operations
Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
Net Capital Spending
Don’t forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a return of net working capital.
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What is the difference between independent and mutually exclusive
projects?
Projects are:
independent, if the cash flows of one are unaffected by the acceptance of the other.
mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
IM| Sciences Financial Management
An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get products across a river.
IM| Sciences Financial Management
Normal Cash Flow Project:
Cost (negative CF) followed by aseries of positive cash inflows. One change of signs.
Nonnormal Cash Flow Project:
Two or more changes of signs.Most common: Cost (negativeCF), then string of positive CFs,then cost to close project.Nuclear power plant, strip mine.
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Inflow (+) or Outflow (-) in Year
0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
IM| Sciences Financial Management
The Average Accounting Return Rule
Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by
management Disadvantages:
Ignores the time value of moneyUses an arbitrary benchmark cutoff rateBased on boor values, not cash flows and market values
Advantages:The accounting information is usually availableEasy to calculate
Investent of ValueBook Average
IncomeNet AverageAAR
IM| Sciences Financial Management
What is the payback period?
The number of years required to recover a project’s cost,
or how long does it take to get the business’s money back?
IM| Sciences Financial Management
Payback for Project L(Long: Most CFs in out years)
10 8060
0 1 2 3
-100
=
CFt
Cumulative -100 -90 -30 50
Payback L 2 + 30/80 = 2.375 years
0100
2.4
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Project S (Short: CFs come quicrly)
70 2050
0 1 2 3
-100CFt
Cumulative -100 -30 20 40
Payback S 1 + 30/50 = 1.6 years
100
0
1.6
=
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Strengths of Payback:
1. Provides an indication of a project’s risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the payback period.
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10 8060
0 1 2 3
CFt
Cumulative -100 -90.91 -41.32 18.79
Discountedpayback 2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discountedrather than raw CFs.
PVCFt -100
-100
10%
9.09 49.59 60.11
=
Recover invest. + cap. costs in 2.7 yrs.
IM| Sciences Financial Management
.
10t
tn
t r
CFNPV
NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.
.
10
1
CFr
CFNPV t
tn
t
IM| Sciences Financial Management
What’s Project L’s NPV?
10 8060
0 1 2 310%
Project L:
-100.00
9.09
49.59
60.1118.79 = NPVL NPVS = $19.98.
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Rationale for the NPV Method
NPV = PV inflows - Cost= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.
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Using NPV method, which project(s) should be accepted?
If Projects S and L are mutually exclusive, accept S because NPVs > NPVL .
If S & L are independent, accept both; NPV > 0.
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Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forcesPV inflows = cost. This is the sameas forcing NPV = 0.
IM| Sciences Financial Management
.
10
NPVr
CFt
tn
t
t
nt
t
CF
IRR
0 10.
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
IM| Sciences Financial Management
What’s Project L’s IRR?
10 8060
0 1 2 3IRR = ?
-100.00
PV3
PV2
PV1
0 = NPV
Enter CFs in CFLO, then press IRR:IRRL = 18.13%. IRRS = 23.56%.
IM| Sciences Financial Management
Rationale for the IRR Method
If IRR > WACC, then the project’s rate of return is greater than its cost-- some return is left over to boost stocrholders’ returns.
Example: WACC = 10%, IRR = 15%.Profitable.
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IRR Acceptance Criteria
If IRR > r, accept project.
If IRR < r, reject project.
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Decisions on Projects S and L per IRR
If S and L are independent, accept both. IRRs > r = 10%.
If S and L are mutually exclusive, accept S because IRRS > IRRL .
IM| Sciences Financial Management
Construct NPV Profiles
Enter CFs in and find NPVL andNPVS at different discount rates:
r
0
5
10
15
20
NPVL
50
33
19
7
NPVS
40
29
20
12
5 (4)
IM| Sciences Financial Management
-10
0
10
20
30
40
50
60
0 5 10 15 20 23.6
NPV ($)
Discount Rate (%)
IRRL = 18.1%
IRRS = 23.6%
Crossover Point = 8.7%
r
0
5
10
15
20
NPVL
50
33
19
7
(4)
NPVS
40
29
20
12
5
S
L
IM| Sciences Financial Management
NPV and IRR always lead to the same accept/reject decision for independent projects:
r > IRRand NPV < 0.
Reject.
NPV ($)
r (%)IRR
IRR > rand NPV > 0
Accept.
IM| Sciences Financial Management
Mutually Exclusive Projects
r 8.7 r
NPV
%
IRRS
IRRL
L
S
r < 8.7: NPVL> NPVS , IRRS > IRRL
CONFLICT r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT
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Two Reasons NPV Profiles Cross
1. Size (scale) differences. Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects.
2. Timing differences. Project with faster paybacr provides more CF in early years for reinvestment. If r is high, early CF especially good, NPVS > NPVL.
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Reinvestment Rate Assumptions
NPV assumes reinvest at r (opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects.
IM| Sciences Financial Management
Managers lire rates--prefer IRR to NPV comparisons. Can we give them a
better IRR?
Yes, MIRR is the discount rate whichcauses the PV of a project’s terminalvalue (TV) to equal the PV of costs.TV is found by compounding inflowsat WACC.
Thus, MIRR assumes cash inflows are reinvested at WACC.
IM| Sciences Financial Management
MIRR = 16.5%
10.0 80.060.0
0 1 2 310%
66.0 12.1
158.1
MIRR for Project L (r = 10%)
-100.010%
10%
TV inflows-100.0
PV outflowsMIRRL = 16.5%
$100 = $158.1
(1+MIRRL)3
IM| Sciences Financial Management
Why use MIRR versus IRR?
MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.
Managers like rate of return comparisons, and MIRR is better for this than IRR.
IM| Sciences Financial Management
When there are nonnormal CFs and more than one IRR, use MIRR:
0 1 2
-800,000 5,000,000 -5,000,000
PV outflows @ 10% = -4,932,231.40.
TV inflows @ 10% = 5,500,000.00.
MIRR = 5.6%
IM| Sciences Financial Management
Accept Project P?
NO. Reject because MIRR = 5.6% < r = 10%.
Also, if MIRR < r, NPV will be negative: NPV = -$386,777.
IM| Sciences Financial Management
S and L are mutually exclusive and will be repeated. r = 10%. Which is
better? (000s)
0 1 2 3 4
Project S:(100)
Project L:(100)
60
33.5
60
33.5 33.5 33.5
IM| Sciences Financial Management
S LCF0 -100,000 -100,000CF1 60,000 33,500Nj 2 4I 10 10
NPV 4,132 6,190
NPVL > NPVS. But is L better?Can’t say yet. Need to perform common life analysis.
IM| Sciences Financial Management
Note that Project S could be repeated after 2 years to generate additional profits.
Can use either replacement chain or equivalent annual annuity analysis to mare decision.
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Project S with Replication:
NPV = $7,547.
Replacement Chain Approach (000s)
0 1 2 3 4
Project S:(100) (100)
60 60
60(100) (40)
6060
6060
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Compare to Project L NPV = $6,190.Compare to Project L NPV = $6,190.
Or, use NPVs:
0 1 2 3 4
4,1323,4157,547
4,13210%
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If the cost to repeat S in two years rises to $105,000, which is best? (000s)
NPVS = $3,415 < NPVL = $6,190.Now choose L.NPVS = $3,415 < NPVL = $6,190.Now choose L.
0 1 2 3 4
Project S:(100)
60 60(105) (45)
60 60
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Year0123
CF ($5,000) 2,100 2,000 1,750
Salvage Value $5,000 3,100 2,000 0
Consider another project with a 3-year life. If terminated prior to Year 3, the machinery will have positive salvage
value.
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1.751. No termination
2. Terminate 2 years
3. Terminate 1 year
(5)
(5)
(5)
2.1
2.1
5.2
2
4
0 1 2 3
CFs Under Each Alternative (000s)
IM| Sciences Financial Management
NPV(no) = -$123.
NPV(2) = $215.
NPV(1) = -$273.
Assuming a 10% cost of capital, what is the project’s optimal, or economic life?
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The project is acceptable only if operated for 2 years.
A project’s engineering life does not always equal its economic life.
Conclusions
IM| Sciences Financial Management
Choosing the Optimal Capital Budget
Finance theory says to accept all positive NPV projects.
Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
An increasing marginal cost of capital.
Capital rationing
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If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
IM| Sciences Financial Management
Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
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Example of Investment RulesPayback Period:
Project AProject B
Time CF Cum. CF CF Cum. CF
0 -200 -200-150 -150
1 200 050 -100
2 800 800100 0
3 -800 0150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
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The Good-Buy Project Appraisal